Managing and Measuring

Working Capital
Operating and Cash Cycles
The operating cycle is the number of days
that inventory is held before it is sold and
the number of days that a receivable is held
before collection.

The cash conversion cycle is the operating

cycle minus the average age of accounts
payable.
Example: Assume that a company has an average age of inventory of 120
days, an average age of accounts payable of 100 days and an average age of
accounts receivable of 40 days.
The operating cycle is 160 days and the cash cycle is 60 days.

Operating Cycle = 160 Days

120 Days Sales in 40 Days

Inventory Sales in AR

Cash
Conversion
−100 Days Purchases
Cycle = 60 in Accounts Payable
Days
Working Capital
Current assets
– Current liabilities
= Working capital
Types of Working Capital
The minimum amount of working capital that
is maintained at all times is called
permanent working capital.

Increases that occur from time to time are

called temporary working capital.
How Much Working Capital
The amount of working capital a company
should maintain is a question for
management.
Changing Working Capital Amount
May increase net working capital by:
• Increasing current assets, and/or
• Decreasing current liabilities.

May decrease net working capital by:

• Decreasing current assets, and/or
• Increasing current liabilities.
Components of Working Capital
1. Cash and cash equivalents
2. Marketable securities
3. Accounts receivable
4. Inventory
Cash Management
Cash Management
Factors that influence how much cash is held
include:
• How much cash is needed in the near future
• The amount of risk a company is willing to take
• The level of other short-term assets that a
company holds
• Interest rates on other short-term investments
• At what point in its operating cycle it is in.
Reasons to Hold Cash
There are four main reasons to hold cash:
1. Medium of exchange
2. Precaution
3. Speculation
4. Compensating balance
Goals of Cash Management
1. Accelerate cash inflows
2. Slow down cash outflows
The Float
The company paying has what is called
disbursement float.
The company receiving the money has what
is called collection float.
Collection Float
Total collection float for the receiving company
has three components:
1. Mail float
2. Processing float
3. Clearing float
Accelerating Cash Inflows
A company can accelerate cash inflows
through the following:
• Mailing invoices as soon as possible.
• Credit terms that encourage prompt
payment.
• Using electronic data interchange (EDI).
• Accepting credit cards / wire transfers.
• Using a lockbox system.
Lock Box System
Company maintains special post office boxes,
called lockboxes, in different locations around
the country.
Invoices sent to customers contain the address of
the lockbox nearest to each customer so
customers send their payments to the closest
lockbox.
The company authorizes local banks to check
these post office boxes as often as is
reasonable, given the number of receipts
expected.
Lockbox Benefits
The benefit from a lockbox system is calculated as:
1. Calculate the amount of cash collected each day.
2. Multiply by the number of days that the collection
float will be reduced.
3. Multiply the increase in the cash balance by the
interest rate at which the company can invest.
4. Compare the amount of benefit to the company
to the cost they will pay for the new system.
Example: JJF Wholesale has an average collection delay of 8
days from the time a customer mails a check to the time the funds
become collected funds that it can draw on. Management has
concluded that by using a lockbox system it will be able to reduce
collection time to 5 days. The cost of this lockbox system is
expected to be $32,000 per year to operate.
The following information is known:
Annual bank interest 3%
Average number of daily payments to lockbox 1,000
Average size of payments $400
The company needs to determine whether the lockbox system is
a worthwhile investment.
1. The average daily collections are $400,000 (1,000 checks per
day × $400 average amount per payment).
2. If the new system is adopted, the collection period will be
reduced by three days. This three-day reduction in the
collection float will lead to an increase in the average cash
balance of $1,200,000.
3. The company will be able to invest that $1,200,000 and earn
an annual return of 3%, or $36,000 over the course of a year
($1,200,000 × .03).
4. Given that the benefit of the lockbox system is $36,000 per
year and the cost of the lockbox system is $32,000, the
company should make the investment and adopt the lockbox
system.
Slowing Cash Outflows
A company can slow cash outflows by paying
as close to the deadline as possible, except
when using cash discounts is beneficial.
Paying Within Discount Period
Cost of NOT Taking discount:
360 Discount %
Total period for payment – x 100% - Discount %
period for discounted
payment

If this is higher than cost of capital, company

should pay WITHIN discount period.
The Cost of NOT Taking Discount
The cost of not taking the discount arises because
the company has two options:
1. It can pay the money early and take the discount
and pay less money, or
2. It can wait until the full amount is due and pay it
then but pay more money (the full amount due).
The difference between the amount paid early and
the amount paid later can be considered to be
interest “charged” for paying later.
Example: Organics, Inc. received a $100 invoice from a supplier
with terms of 3/10, net 30. If Organics pays within 10 days, it will
receive a 3% discount but if payment is not made within 10 days,
then the entire amount is due in 30 days.
The cost of not taking the discount is calculated as follows:
[360 / (30 – 10)] × [0.03 / (1.00 – 0.03)] = 0.5567 or 55.67%

The annualized cost to Organics of not taking this vendor’s

discount, expressed as an annual interest rate, is 55.67%.
The company has $200 in its bank account when the invoice is
received (April 1). The company can earn interest on its unused
cash balances at the rate of 3% per annum. The two options the
company has are to pay on April 10 or April 30.
The company pays on April 10:
If Organics pays on April 10, it will pay $97 on that date, leaving
$103 in the bank. Therefore, Organics will earn interest on $200
for 10 days, then interest on $103 for 20 days and still have $103
in the bank in cash not counting the interest earned. Under this
scenario, the company will have $103.34 in the bank at the end of
the month (using a 360-day year to annualize the interest
amounts):
Interest on $200 for 10 days ($200 × 0.03 ÷ 360 × 10) $ 0.17
Interest on $103 for 20 days ($103 × .03 ÷ 360 × 20) 0.17
The $103 in cash 103.00
Total $103.34
The company pays on April 30:
If the company pays on April 30, it will pay $100 on April 30.
Therefore, the company will earn interest on $200 for 30 days.
The company will have $100 left in the bank plus $0.50 interest at
the end of the month:
Interest on $200 for 30 days ($200 × 0.03 ÷ 360 × 30) $ 0.50
The $100 in cash 100.00
Total $100.50

If Organics pays on April 10, it will have more money in the bank
at the end of the month than ($103.34) it would have had if it had
paid on April 30 ($100.50). Therefore, Organics should take the
discount.
At an interest rate of 55.67% earned:
Making the same calculations using 55.67% as the interest rate
earned on cash illustrates that 55.67% is the interest rate at which
Organics would be indifferent between paying early and taking the
discount or waiting to pay until the due date, because at an
interest rate of 55.67%, the total amount in the bank at the end of
the month will be the same—$109.28—whether the company
pays on April 10 or on April 30:
The company pays on April 10:
Interest on $200 for 10 days ($200 × 0.5567 ÷ 360 × 10) $
3.09
Interest on $103 for 20 days ($103 × 0.5567 ÷ 360 × 20) 3.19
The $103 in cash 103.00
The company pays on April 30:
If the company could earn 55.67% interest on its cash for 30
days, and if it paid on April 30, the two choices would be equal.
Interest on $200 for 30 days ($200 × 0.5567 ÷ 360 × 30)$ 9.28
The $100 in cash 100.00
Total $109.28
If the company can earn any interest rate up 55.67% on its cash,
the company should pay early and take the discount. At an
interest rate of 55.67%, the company is indifferent. If the company
is able to earn more than 55.67% interest (which is highly
doubtful), the company should pay on April 30.
Marketable Securities
Management
Marketable Securities Management
Balance risk and return.
Tax implications if something is not taxable.
Types of Marketable Securities
1. Treasury bills
2. Certificates of deposit
3. Money market accounts
4. Higher-grade commercial paper
5. Other types
Company needs to manage its cash / cash
equivalent balance.
T-Bills Sold at Discount
Face value of the T-Bill
− Interest earned while T-Bill is outstanding

= Cash price of the T-Bill

Effective interest rate:

Interest earned while outstanding x 360
Discounted selling price Days to maturity
Two Models for Management
1. Baumol Cash Management Model
2. Miller-Orr Cash Management Model
1. Baumol Cash Management Model
Calculates the optimal amount of cash to
receive every time it converts marketable
securities to cash.
The model balances the cost of converting
marketable securities into cash with the
interest benefit of holding marketable
securities.
Baumol Formula
OC = 2bT
i
OC = The optimal level of marketable
securities to convert to cash
b = Fixed cost per transaction
T = Total demand for cash for the period
i = Interest rate for marketable
securities, or the opportunity cost lost by
holding cash instead of marketable
securities
Example: HJK Corporation’s demand for cash during a year’s
time is $500,000. Each time HJK sells securities to raise cash, it
pays a brokerage commission of $10. The interest rate HJK earns
on the securities is 4% per year.
Given this information: b = $10; T = $500,000; i = 0.04

Each time HJK sells securities to raise cash, it should sell $15,811
worth of securities. Since HJK needs $500,000 in cash during a
year’s time, HJK will need to sell securities valued at $15,811 32
times during the year ($500,000 divided by $15,811), or
approximately every 11 days (365 days divided by 32).
Miller-Orr Cash Management Model
Creates an upper and a lower limit for the
cash balance that a company holds.
As long as the cash balance is between these
two levels, there is no need for the
company to make any cash transactions to
either increase or decrease the balance.
Accounts Receivable Management
Accounts Receivable Management
Must balance increased sales from extending
credit and the cost to extend credit.
Credit Policy
One of the main factors in receivables
management is the credit policy (i.e. who will
receive credit).
• Credit terms
• Credit standards
• Credit scoring
Monitoring Receivables
An aging schedule is a common analytical tool
used in conjunction with receivables and their
evaluation.
Inventory Management
Inventory Management
Balance cost and benefit of inventory.
A company should minimize its total inventory
costs.
A small per unit decrease in the cost of
holding inventory can become a very large
amount when multiplied by the number of
units held in inventory.
Costs of Inventory
There are five main categories of costs of
inventory:
1. Purchasing costs
2. Ordering
3. Carrying
4. Stockout costs
5. Inventory shrinkage
Inventory Terms
Lead time
Safety stock
• The variability of the lead time
• The variability of the demand for the
product
• The cost of a stockout
Reorder point
Average inventory
Example: The average lead time is 10 days and the average
daily usage of widgets is 20. The company has determined that
safety stock should be 100 units. The reorder point will be when
inventory on hand gets down to 300 units, as follows:
Reorder point =
(Average daily usage × Average lead time) + Safety Stock
(20 × 10) + 100 = 300 units
The average inventory level will be:
[(# of units ordered each time) ÷ 2] + Safety Stock
If the company orders a 15-day supply each time it places an
order, it will order 300 units each time (15 days × 20 units per
day). Therefore, its average inventory level will be (300 ÷ 2) +
100, or 250 units.
Economic Order Quantity Calculation

EOQ = 2aD
K
where
a = variable cost of placing an order
D = periodic demand
K = carrying cost per unit per period
Just-in-Time Inventory Systems
The goal of a JIT system is to minimize the
level of inventories that are held in the plant at
all stages of production, while meeting
customer demand in a timely manner with
high-quality products at the lowest possible
cost.
Inventory Turnover and Gross Profit
The inventory turnover ratio and the gross
profit margin can be evaluated together to
get some insight into whether average
inventory is too high.
A “rule of thumb” is that if the inventory
turnover ratio multiplied by the gross profit
margin is 1.0 or higher, the average
inventory is not too high.
Example: A company’s annual revenue is $1,000,000 and its annual cost of
sales is $700,000. The company carries average inventory of $140,000.
The company’s gross profit margin is ($1,000,000 − $700,000) ÷ $1,000,000,
or 0.30.
The company’s inventory turnover ratio is $700,000 ÷ $140,000, or 5 times.
Gross profit margin multiplied by inventory turnover = 0.30 × 5, or 1.5. Because
1.5 is higher than 1.0, this company’s inventory is not too high according to the
“rule of thumb.”
Given the same revenues and cost of sales, the company now allows its
average inventory to increase to $250,000.
The company’s inventory turnover ratio is now $700,000 ÷ $250,000, or 2.8
times. Note that the inventory is now turning over only 2.8 times per year,
whereas previously it was turning over 5 times per year.
Gross profit margin multiplied by inventory turnover = 0.30 × 2.8, or 0.84. That
is lower than 1.0, so the company’s inventory may be too high.
Short-term Financing:
Trade Credit
Short-term Financing
The questions of short-term financing relate to
the company’s current liabilities that need
to be paid or settled within 12 months.
Three main sources of short-term financing:
• Trade credit
• Bank loans
• Factoring of receivables
Trade Credit Financing
Trade credit is a source of credit that arises
from the process of purchasing an item on
credit.
Trade credit is usually the largest source of
short-term financing for many small and
medium-sized businesses.
The Cash Discount
If the cost of not taking the discount is higher
than the cost of short-term borrowing, the
company should take the cash discount and
pay within the discount period.
Example: A vendor offers terms of 2/10, net 30. If the company
pays within 10 days, it will receive a 2% discount. If payment is
not made within 10 days, then the full (undiscounted) amount is
due in 30 days.
The cost of not taking the discount is calculated as follows:
360 x 0.02 = 0.3673 or 36.73%
30 – 10 1.00 – 0.02

The annualized cost to the company of NOT taking this vendor’s

discount, expressed as an annual interest rate, is 36.73%.
This rate means that if the company does not pay on day 10, the
company is essentially borrowing money to pay instead on day 30
at an annual rate of 36.73%.
Short-term Financing:
Bank Loans
Bank Loans
Commercial banks offer many different types
of loans to business borrowers with
different ways that interest is calculated and
paid.
Can be secured or unsecured.
The Effective Interest Rate
Need to be able to calculate the effective interest
rate when there is:
1. A compensating balance
2. Discounted interest
3. A compensating balance and discounted
interest

The keys items are how much interest is paid and

how much “new money” is received.
1. Compensating Balances
Some amount of money needs to be kept at
the bank during the loan.
Interest is paid on the full amount, even if
come of the loan amount is kept as the
compensating balance.
Compensating Balance Formula
Annualized interest paid on full amount
borrowed – Annualized interest received on
cash deposited to meet compensating
balance requirement, if any
Amount of the loan – The amount of the loan
that was required to be kept in bank to meet
the compensating balance requirement
Example #1: Assume a one-year loan of $100,000 at 6% simple
interest that requires a $20,000 compensating balance.
Annual simple interest is $6,000 and the usable loan balance is
$80,000 ($100,000 − $20,000), so the effective annual interest
rate is:

$6,000 ÷ $80,000 = 0.075 or 7.5%.

Example #2: However, if the company already has an average
balance of $10,000 on deposit in the bank, then it would need to
add only $10,000 to its existing deposit to meet the $20,000
requirement.
Now, the effective annual interest rate would be calculated as:

$6,000 ÷ $90,000 = 0.0667 or 6.67%.

Example #3: Now assume that the bank will pay 2% interest per
annum on the money deposited in the bank as a compensating
balance and that the company already maintains a $10,000
balance at the bank.
The effective interest expense will be the interest expense
reduced by the amount of interest earned on the additional money
that needed to be deposited in order to meet the compensating
balance requirement, which is $10,000.
The 2% interest on $10,000 is $200, which reduces the effective
interest expense (the numerator) to $5,800 ($6,000 minus $200).
Earning interest on the compensating balance reduces the
effective simple interest rate to 6.44%.
$5,800 ÷ $90,000 = 6.44%
2. Loans with Discounted Interest
Discounted interest is interest that is ‘withheld’
when the loan is given.

Interest on the amount of the loan

Borrowed amount – interest “withheld”
Example: Assume a $100,000 one-year bank loan with 4%
discounted interest, principal and interest due in one year.
Because the interest of $4,000 is discounted, this amount will not
be disbursed to the borrower with the rest of the loan proceeds.
So, the borrower is paying $4,000 in interest but receiving only
$96,000 in available proceeds.
When the loan matures, the borrower repays $100,000, which
includes the $96,000 principal disbursed plus the $4,000 in
interest.

Thus, the effective interest rate is 4.17%

$4,000 ÷ $96,000 = 4.17%
3. Compensating Balance and Discounted
Interest
A loan may have both a compensating
balance requirement and discounted interest.
Example: Assume the same one year, $100,000, 4% discounted
loan as in the previous example, but the bank also requires a
10% compensating balance.
The borrower will have the use of only $86,000, because the
$4,000 of discounted interest will be deducted from the loan
proceeds and the borrower will not have the use of the $10,000 of
the loan proceeds required for the compensating balance.
However, the borrower must pay interest as if it had received the
full $100,000.

The effective rate of interest to be paid on the loan will be 4.65%.

$4,000 ÷ $86,000 = 4.65%
 Short-term Financing:
Factoring Receivables and
Other Sources
Factoring Receivables
Factoring receivables occurs when the owner
sells the receivables to another party.
Cash Received from Factoring
The amount of money that is actually received
from the factor of the receivables is reduced by:
• Factoring fee: the more risk related to
receivables, the higher the amount.
• Interest charge: almost always higher than
market rate.
• Allowance for returns: if all receivables are
collected, the allowance will then be paid to the
seller.
Ways of Factoring
With recourse
Without recourse
Advantages of Factoring
May reduce the costs of collection by
outsourcing this function.
Bad debts may be eliminated because the risk
of noncollection is passed to the factor.
Cash Received Calculation
Cash to be received from factoring:
Face amount of receivables
– Reserve amount for returns
– Factors fee
= Amount needed to pay interest on
– Interest on amount of cash to be
received
= Cash to be received from factoring
Example: The factor charges a 4% factor’s fee plus
12% interest on all monies that are advanced to the
seller. The factor also holds back 7% for potential sales
returns. The receivables are being sold without
recourse. The receivables being sold total $150,000 and
the weighted-average estimated collection time is 120
days. The seller receives the proceeds immediately. The
amount of proceeds to the seller is calculated as
follows:
Balance of receivables submitted $ 150,000
Less: 7% holdback on gross receivable (10,500)
Less: 4% factor’s fee on gross receivable
(6,000)
Funds available before estimated interest charge
$ 133,500
Less: 12% interest for 120 days
($133,500 × 0.12 ÷ 360 × 120) (5,340)
Cash available to the seller to withdraw $128,160
In addition to the $128,160 the seller receives at the
time of factoring, any receivables collected in excess of
$139,500 ($150,000 − $10,500) will be paid to the seller
because the factor withheld that $10,500 as a protection
against some of the sales being returned and the
receivables not being collected as a result.
If all of the receivables are ultimately collected when
expected, the total cost to the seller of factoring the
receivables will be $11,340 ($6,000 factor’s fee + $5,340
interest). The total factoring cost must be compared to
the costs that the selling company would have incurred
if it had operated its own collections department and the
cost of other financing options available.
Other Sources of Financing
Secured and unsecured sources of financing.
Secured Sources of Financing
Revolving line of credit
Warehouse financing
Inventory financing
Transaction loan
Chattel mortgage
Unsecured Sources of Financing
Trade credit (accounts payable)
Accrued expenses
Line of credit (other than a revolving line of
credit)
Commercial paper
Bankers’ acceptances (BAs)
Maturity Matching for
Working Capital Management
Each type of asset to be financed is matched
with a source of financing that has the
same maturity time frame.
For working capital management, this means
that current assets should usually be
financed with current liabilities.
Using this same approach, property, plant and
equipment, are financed with long-term
capital.